Category Archives: Investment

McKinsey Global Institute continues to run with a series of reports on the global credit bubble that spurned the Great Recession. The latest titled “Debt and (Not Much) Deleveraging” takes up the story seven years after the crisis (click for larger image).

The report shines a spotlight on the world’s growth problem. Other things being equal, higher debt should translate into higher effective demand, either through increased investment or greater consumption. Again, other things being equal, more investment should result in a rising capital stock, which in turn should lead to more growth. Further, if growth were accelerating, then the debt-to-GDP ratio should be falling. Yet this text book economics isn’t panning out. Instead, we have rapidly rising debt and anaemic GDP growth. Result: debt-to-GDP grows and grows (click for larger image).

This is interesting, but doesn’t really tell us anything new. And the McKinsey report avoids the big questions, the biggest of all being “does debt matter?”

Commentaries at the doomer end of the economic blogosphere suggest that debt matters more than anything else–and, for some, burgeoning debt means the world is on the verge of a financial panic and subsequent collapse. But the relationship between the real economy and the financial economy is a complex thing. I can’t count the number of times that people confuse debt with stuff. Debt is not stuff: debt is a claim on stuff. Expand, contract or shuffle the debt–do what you will–and the same amount of stuff still remains.

Take the purest form of monetary collapse: the Weimar German hyperinflation between 1921 and 1923. During this period, fiat money became worthless. Yet the real assets of the economy remained intact. Germany had almost the same number of factories in 1923 as it did in 1921. It had the same number of engineers, even if many lost their jobs. And, ultimately, this real economy was sufficiently robust to reignite within a year or two. Money died in 1923 Germany, the real economy didn’t.

What’s more, the real German economy then took a second financial punch in the form of the Great Recession in 1929. Yet despite undergoing all this turmoil (which makes our 2008 crisis look insipid by comparison), the German real economy had enough inherent strength to go on to support the expansionist policies of the Third Reich for a decade.

So when money died in Germany, the real economy didn’t. By contrast, what did die along with money were many of the original ownership claims on the real assets. Who owned what in 1924 (after the situation stabilised) was very different from who owned what in 1920 (before hyperinflation took off). Moreover, during the hyperinflation years, assets remained idle and incomes fell. So there were real effects–they just weren’t ever-lasting.

During the 2008/09 credit crisis we similarly witnessed under-utilised assets, and the claims on those assets were shuffled around to a certain extent. But the real assets that make up the real economy lived on. True, we had what Austrian economists call mal-investment. That is, the financial economy directed the real economy to make some real assets that no one wanted a year or two down the road. But the largest dead assets of America, such as the decaying factory and residential blocks of Detroit, are not the result of a credit bubble that went pop, but rather are due to far deeper and slow-moving underlying real economy forces.

For this reason, I don’t see debt as in the same league of existential threats to well-being as climate change or resource depletion.

To restate my argument: on the positive side, our most-pressing problem is not that of a dysfunctional financial system. But on the negative side, this means that the financial system will provide only limited help in solving our existing challenges.

Before the financial crash, it seemed that modern finance, derivatives and all, had led to a step-change improvement in matching limited resources with limitless needs (what economics is all about). That step-change improvement now appears a mirage. But this also means that real change will ultimately have to come from changing the real economy–and that, in reality, is a far tougher thing to do than fiddling around with our banks and brokers.

I’m taking my charts today from the just-published Report of the Commission on Inclusive Prosperity, chaired by Larry Summers and Ed Balls. Summers, one of the highest profile economists in the world, was in London yesterday (on the way to Davos), promoting the report itself and describing the challenge of how to combat secular stagnation. Yesterday, I listened to Summers at a lecture held at the LSE, a podcast of which can be found here.

First, a restatement of the problem. Growth has slowed in almost all advanced countries (click for larger image):

And what growth there has been has gone to the rich:

In short, for the bottom 90%, productivity and income have diverged.

While admitting there are supply side factors causing the economic slowdown (such as poor demographics), Summers places most emphasis on the demand side as the root cause of the problem, particularly with repsct to investment.

Critically, the relative price of investment goods has collapsed, making investment a meagre source of effective demand. By way of example, Summers points to the behemoth of the 1970s, IBM. The computer giant of its time had a repeated need to access capital markets in order to finance its investment plans and grow. Apple, however, generates more cash than it knows what to do with. Indeed, it is a source of liquidity in the capital markets through carrying out continued share buybacks.

Similarly, Summers notes that a company used to be partly valued on how much ‘stuff’ it had on its balance sheet, but now this is almost an irrelevance. So we have a situation where Whatsapp is worth $17 billion, with minimum assets and employees, but Sony, with an army of employees and a raft of factories, is only worth $16 billion. As a result, the price of money has fallen to zero.

Summer’s prescription: if the private sector doesn’t want to invest regardless of how low interest rates go, the state should step in, taking advantage of bargain basement borrowing rates to massively upgrade its infrastructure.

I am broadly sympathetic. However, I would point out that another state suffering secular stagnation, Japan, has tried the government-financed mega infrastructure investment strategy before. Indeed, for a time, academics dubbed Japan the ‘construction state’. This frenetic activity, however, did little to raise long-term growth rates. Sometimes, when growth has gone, it’s gone.

I’ve been looking for an excuse to link to a delightful commentary by the British novelist Will Self, carried by the Financial Times. But before I do, below is my chart appetiser, courtesy of the UK’s Office of National Statistics:

Obviously, the UK was a land of the renter and the rentier before WW2; few but the relatively wealthy could afford to own their own home. Also noteworthy is the rise and fall of social housing. In Self’s piece, titled “A rentier nation’s fading dream of home” (free access after registration with the FT), the author retells the failure of Thatcher’s grand sale of council housing stock, the ultimate aim of which was to make Tory voters of all of England by way of expanding the property-owing class. It didn’t quite work out that way:

The current housing crisis is not so much emblematic of a transmogrification from a social market economy to a neoliberal one. It is constitutive of that process: the asset transfer from the state to the rich; the pump-priming of the value of those assets; the forcing of the poor into more expensive private rental accommodation — all of which measures are underpinned by a financial system heavily dependent on mortgage lending. Of all British bank loans, 76 per cent are for property, and 64 per cent for residential property alone. Any radical reform of the system entailing a fall in land and house prices would, ipso facto, result in a fundamental destabilisation of the banking system.

I quibble at bit at criticising Will Self’s mixing of prose, polemic and the underlying problem–but I will. At heart, we are just not building enough houses. From a Civitas report out last week titled ‘The Future of Private Renting“:

On top of this, we face the growing problem of secular stagnation (more to come on that tomorrow), the only treatment for which is deemed by the policy-making classes to be huge dollops of easy money by way of a massive central bank-directed quantitative ease (QE). The economics 101 definition of inflation is too much money chasing too few goods. In the UK housing market, we have ever more amounts of money chasing ever fewer new-build houses. Which leads to this:

QE, as operated through buying up bonds and forcing down interest rates, rewards those who have assets at the expense those who don’t. So the rentiers property becomes worth more, allowing he or she to leverage up with ultra cheap money, and so buy even more. In this game, if you start with nothing, you never catch up.

But it doesn’t have to be this way. The government could choose to build houses itself, funded by bond issuance that the central bank buys; if you were a populist by persuasion, you could call this the people’s QE. But how can we afford to pay interest on all those new 30-year housing bonds I hear you ask. Bloomberg tells us that 30-year UK gilts are yielding 2.16%. Private sector low-end rental property is providing net yields after maintenance costs of double that or more.

Here’s a toast to aggressive and acquisitive rental landlords; that is, government-backed ones.

Note we are talking about wealth. This is important because most studies of the 1% focus on income. Wealth is difficult to measure, especially for the uber-rich, which is why this is a landmark study. The authors backed out their wealth estimates using investment income tax return records. In the process, you can see that those poor 1% to 0.5% have been struggling. Forget the squeezed middle, next up is the squeezed upper middle class and then the squeezed lower upper class (click for larger image)?

Seriously, the charts suggest the precariousness of the game the super rich are playing. Immense wealth brings immense political power, at least in the United States. But as you eliminate more and more cohorts from the winners’ enclosure, even the most well-financed lobbying machine will start to struggle.

So we have an ever-growing share of income by the 0.1%. But the income edge of the 0.1% then starts compounding away as return on investment, which then gets passed on to children and grandchildren if the tax regime permits (which it currently does). And– following Piketty’s iron law of inequality–when r (the return on investment) is larger than g (economic growth), wealth inequality explodes. What eventually stops this process is war, revolution, or, more prosaically, government redistribution. We shall see how this cycle ends.

So will U.S. shale gas save Europe from a belligerent Russia? This from The Financial Times (here, free access after registration):

The US should make it easier for Europeans to buy American natural gas in order to reduce its allies’ dependence on Russian energy, the top Republican in the House of Representatives has said.

John Boehner’s statement on Tuesday brought national security concerns into the centre of a debate on how the US should use supplies of oil and gas from its shale.

In my humble opinion, reportage on the Ukrainian crisis has generally been dire, but finding any decent analysis of the West’s reliance on Russian oil and natural gas has been especially hard. Let’s start with the big picture for gas. From the International Energy Agency‘s “Key World Energy Statistics 2013” (click for larger image):

From the tables, we see that Russia is the second largest natural gas producer behind the U.S., but it is the world’s largest exporter. Russia also exports 28% of all it produces.

As always with energy statistics, every publication has its preferred unit of measurement, so we have to do some very simple math to compare. One cubic metre of natural gas is equivalent to 35.3 cubic feet, so Russia’s 185 billion cubic metres (bcm) of natural gas exports translates into roughly 6.5 trillion cubic feet.

And where does it go (from the Energy Information Administration‘s Russian analysis here)?

Shale gas to the rescue? The U.S. government’s Energy Information Administration (EIA) released this graph in its “Annual Energy Outlook 2014“.

The chart shows LNG exports kicking in around 2016 and then rising to 2 trillion cubic feet in 2020 and then plateauing at approximately 3 trillion in 2025. At the same time, imports will be declining by around 1 to 2 trillion cubic feet or so.

This doesn’t entirely cover current Russian exports of 6.5 trillion cubic feet, but it is certainly a significant amount. Nonetheless, and notwithstanding the fact that U.S. LNG exports will not commence for a couple of years or more, the U.S. change in trade is material.

However, this all assumes an “other things being equal” type of world. But things will certainly not be equal going forward due to one particular country: China. From the EIA’s “International Energy Outlook 2013“.

Accordingly, it is a very moot question as to whether any U.S. origin LNG exports end up in Europe as opposed to the more likely destination of Asia—where insatiable demand will likely translate into premium pricing.

What about oil? Back to the IEA’s tables:

Now this is where it gets interesting. If Vladimir Putin decided not to play nice, then he would likely use oil to turn the screws on the West. As usual, we have a table with different units, but one metric tonne is roughly equivalent to 7.3 barrels of oil. Accordingly, Russia’s 520 million tonnes of production is around 3.8 billion barrels per year. This, in turn, is about 10.3 million barrels per day (bpd)—47% of which goes abroad. In short, he has a 5 million bpd oil cosh to beat the West.

In a recent post, I referred to the IEA’s observation that oil inventories have fallen considerably, mostly due to political troubles in Libya and Iraq, so any explicit, or even implicit, oil threat would be enough to send prices shooting higher—and global financial markets lower. Put another way, current global consumption is a little over 80 million bpd, and excess production capacity is estimated at around 1 to 2 million bpd above that. So if Putin turned the oil tap off, the global oil market would fall into a significant shortfall.

Overall, I see neither U.S. shale gas nor U.S. tight oil having any diplomatic impact on Russia. The major check on any Putin aggression will likely come from Russia’s oligarchs, who all have a major stake in the global capitalist status quo. Will that be enough? I don’t know.

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Now is the time of year when a young (and not so young) person’s fancy lightly turns to thoughts of skiing (not least because of the Sochi Winter Olympics). Few, however, like to talk about the threat that climate change poses for winter sports. This spectre at the feast is met with passive denial—if we pretend it isn’t there, perhaps it will go away. So it is rare to hear a voice from within the industry itself, such as that of Powder Magazine‘s Porter Fox in an Op-Ed piece titled ‘The End of Snow?” in The New York Times, calling for action.

Two weeks ago, I referenced a Mark Lewis article in The Financial Times disputing the peak demand theory for oil (here, free registration at the FT). As a contrast, I thought it worthwhile referring back to a 2013 Steve Kopits interview on resilience.org which gives the opposing argument (here). Personally, I believe that the intersection between price, demand destruction and supply response is too complex to forecast accurately, particularly as these factors all play out over different time horizons. That said, my gut feeling is that oil is already putting a break on GDP growth at the margin, with more turbulence to come.

The U.K. has been plagued by floods over the last couple of months, with the head of the Environment Agency Lord Smith becoming the fall guy for middle England’s frustrations. In a frank letter to The Daily Telegraph, Smith had the temerity to argue that difficult choices have to be made, but this position has produced outrage in the shires. I always find irony in the fact that the political right argues for self-reliance yet runs crying to the state whenever it finds itself on the wrong end of climate change.

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The current oil narrative in the U.S. is one of bountiful supply but structurally reduced demand. Yet Mark Lewis, in The Financial Times, disputes the latter story (here, free registration at the FT). He argues that the last five years have seen a cyclical, not structural, shift in demand. But now that the economy is picking up speed, demand for oil is kicking up a notch. Given the astronomical capital expenditures needed to bring new supply to market, however, the only mechanism able to maintain equilibrium will be the rationing effect of higher prices.

Again in The Financial Times are some fascinating statistics showing that 26% of young adults aged between 20 and 34 now live with their parents in the U.K., up from around 21% in 1996. A prime mover behind this trend is the 13% decline in real median incomes for this age group in the decade from 2001/02 to 2011/12. All part of the new normal.

In my former job running a hedge fund, I learned one great skill that is rarely developed in the general populace; that is, to believe both the buy and sell case for any individual position. So does this mean that I was unable to trade, like a deer caught in the headlights? Not really, because sometimes (but not often) you rate the rationale behind one side of a trade as a little superior than the other—and that’s when you place your bet. This approach can be extended to most things in life. So in the case of my recent series on technology and unemployment (starting here), I looked at a series of papers that suggested we have a serious problem with technology. Given that bias, my inclination is to find intelligent people who say we don’t have a problem. One such person is the progressive economist Lawrence Mishel, who in a blog post last week argues that technology is not the job killer; rather, low wages, inequality and unemployment are caused by other, non-technological factors. My understanding of this topic is highly fluid, with argument and counter-argument going on to my weighing scales. I tilt towards worrying, but am still very receptive to opposing views.

Of course, in the case of climate change, the scales are dramatically weighted to one side—i.e., bad climate change outcomes. Marginally encouraging is the fact that corporations are slowly comprehending climate change risk. As evidence, climate change has elbowed its way back onto the agenda at Davos. The Guardian is one of the few publications to pick up on this trend and has been tracking the various seminars, panel discussions and presentations there (here, here and here). And The New York Times has an informative article by Coral Davenport on how big business is getting more concerned over global temperature rise.